Sunday, April 11, 2010

Fed Interest Rate Targets, Part III

After reading Andolfatto's comment on the previous post, and thinking about it for bit, I think it's confusing (or just wrong) to call some element of the Fed's policy under a regime with positive excess reserves "fiscal policy." The only "fiscal" aspect of current Fed policy is that the Fed has taken over a piece of the activity that was being conducted by Fannie Mae and Freddie Mac.

Now, consider how monetary policy works when the banks are holding positive excess reserves. As discussed in previous post, the relevant policy rate is the interest rate on reserves, which the Fed can set at will. Moving the rate up will tend to increase reserves and reduce currency. Now, what happens if the Fed conducts an open market sale of treasuries. Nothing much important, except that the quantity of reserves drops - essentially one-for-one - with the open market sale. All that has happened is that the financial sector is now holding more treasuries and less reserves - no big deal. Thus, the Fed really has only one instrument available, aside from issues related to the maturity structure of the assets on its balance sheet.

Alternatively, when the banks are holding zero excess reserves overnight, the relevant policy rate is the fed funds rate, and an open market sale of treasuries will move the policy rate up. Not much difference between how monetary policy works in this case and in the other one.

It's possible we should think of monetary policy as being much tighter currently than is widely believed. Think of the reserves as T-bills. We have a very low policy rate (0.25% - the rate on reserves), but the supply of currency has not expanded like the supply of reserves, and we could argue that the world demand for US currency has gone up substantially.